Trusts and Taxes
Summary Revocable trust assets are included in the grantor’s gross estate; the income of that trust is taxed to the grantor. Assets in an irrevocable trust are not included in the grantor’s gross estate. The income of an irrevocable grantor trust is taxed to the grantor. The income of an irrevocable non‐
grantor trust is taxed to the trust and/or the trust beneficiaries. Related information Is Your Trust Defective? Options for Achieving Grantor Trust Status; Estate Planning Basics in depth. Susan is a single mom, with two adult children, Mike and Alice. Susan is working on her estate
plan with her estate planning attorney. Her attorney recommends a revocable trust and an
irrevocable trust. In an effort to better understand trusts, Susan has done some research about the
tax aspects of trusts and is now thoroughly confused. While it is true that the transfer tax rules
and the income tax rules of trusts can be confusing and do not necessarily jive with each other,
let’s see if we can help clear up some of Susan’s confusion. 1
Revocable Trust. Together with recommending that she have a revocable trust, Susan’s
attorney also suggests that she transfer ownership of her stock and real estate to the trust
(“funding” the trust) and name the trust as the beneficiary of most of her life insurance.
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Income Tax. A revocable trust is a popular estate planning document. Susan as the
creator or grantor of the trust can change the trust while she is living, and it becomes
irrevocable upon her death. Because Susan can revoke the trust, it is a grantor trust.
Thus, the income generated by the assets in Susan’s revocable trust is taxed to Susan.2 In
the I.R.S.’s eyes, the trust does not exist as a separate income taxpayer. For example, if
the trust earns $1,000 of dividends, that $1,000 is reported on Susan’s income tax return
as dividends.
This article deals with federal taxes; the reader must always keep in mind any state or local taxes.
§ 676.
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See Circular 230 disclosure at the end of this article.
Advanced Planning Ideas
Wait a sec, Susan says – don’t all trusts have grantors – aren’t all trusts grantor trusts?
The label “grantor trust” is a specific income tax term. And actually, while all revocable
trusts generally are grantor trusts, not all irrevocable trusts are grantor trusts – more on
this later.
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Gift Tax. If Susan transfers assets to her revocable trust, that is not a gift because she
continues to control the asset for her own benefit. 3 If Susan directs that any asset held in
her revocable trust be transferred to someone other than herself, Susan is making a gift to
that person. For example, Susan tells the trustee to transfer 50 shares of ABC stock to
Mike; Susan has made a gift to Mike.
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Estate Tax and Basis. When Susan dies, the trust becomes irrevocable. Due to Susan’s
right to revoke the trust up to the time of her death, all the trust assets are included in
Susan’s gross estate for estate tax purposes. 4 Just as with most assets that Susan owns,
the stock and real estate held in Susan’s revocable trust receive a basis adjustment at
Susan’s death, commonly referred to as a “step up” in basis. 5 For example, when Susan
transfers $1,000 of ABC stock with a basis of $100 to the trust, the trust’s basis is also
$100. Assume that, at her death, the fair market value of that stock is $5,000. The basis
is stepped up to $5,000.
Irrevocable Trust. Susan’s attorney also recommends that she have an irrevocable trust, with
her brother as the trustee and her two children as the trust beneficiaries. Susan will not be a
beneficiary of this trust. The attorney further suggests that Susan make cash gifts to this trust. In
fact, Susan plans to give $500,000 in cash to the trust; part of this gift will pay premiums on a
life insurance policy on Susan’s life.
The irrevocable trust – as its name suggests – cannot be changed. 6 This type of an irrevocable
trust is usually designed to receive gifts from Susan and not be included in her estate.
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Gift Tax. Susan’s $500,000 cash gift to the trust must be reported on a gift tax return.
Depending on the design of the trust, Susan may be able to use her annual exclusions on
this gift. To the extent that she cannot cover the entire gift with her annual exclusions
(probably the case with this large of a gift), then her gift tax exemption will be used. 7 If
she does not have enough exemption, then Susan will pay a gift tax. The trustee might be
able to distribute assets to Mike and Alice (the trust beneficiaries) at times and in
amounts authorized by the trust document. The trustee does not make gifts and, more
importantly, cannot make distributions to Susan.
3
Treas. Reg. § 25.2511-2(c).
§ 2038.
5
§§ 1014(a) and 1014(b)(2). It could also be called a “step down” in basis if the asset’s fair market value is below
its basis. The basis adjustment at death does not apply to certain assets with a deferred income aspect, known as
income in respect of a decedent (IRD). § 1014(c). Common examples of IRD include individual retirement
accounts and qualified plans.
6
Notwithstanding the fact that this irrevocable feature seems to induce amnesia in the minds of the clients who
establish them, causing them to forget this fact.
7
In 2011, the gift tax annual exclusion is $13,000, and the gift tax exemption is $5 million.
4
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Advanced Planning Ideas
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Estate Tax and Basis. Upon Susan’s death, the trust assets are not included in her gross
estate. Hand in hand with that result, the trust assets do not receive a basis adjustment at
Susan’s death. 8 So, if Susan had given $1,000 of ABC stock to the trust, with a basis of
$100, the trust’s starting basis is $100 (i.e., carryover basis) and is not affected by the fair
market value of that stock at Susan’s death. 9
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Income Tax. There are very different results depending on whether the trust is a grantor
trust or a non-grantor trust.
o Grantor Trust. If Susan’s irrevocable trust is a grantor trust, the income generated
by the assets in that trust is taxed to Susan. 10 However, the income is not actually
distributed to Susan. Ummm, that doesn’t seem very fair – Susan pays the
income tax but doesn’t get the income. Actually, this is a very good estate
planning strategy. The trust assets – not subject to estate tax in Susan’s estate –
are not diminished by the payment of income taxes. Rather, Susan’s estate
taxable assets are used to pay this income tax. 11 These rules apply even if the
trustee makes distributions to Susan’s children. So, if the trust’s life insurance is
surrendered with a gain of $50,000, the surrender proceeds stay in the trust or may
be distributed to the beneficiaries, depending on the trust terms, and Susan is
taxed on $50,000.
o Non-Grantor Trust. If Susan’s irrevocable trust is a non-grantor trust, then Susan
will not pay the income tax on the trust’s income. Instead, the income is taxed to
the trust and/or the trust beneficiaries.
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Many of the rules of trust taxation are similar to those rules affecting
individuals. 12
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Ordinary income is taxed at the same rates as individuals,
including qualified dividends; however, the brackets are greatly
compressed. In 2011, the rates range from 15% to 35%, with the
35% bracket starting at only $11,350 of taxable income.
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Long term capital gains are taxed at the same rates as individuals
(top rate of 15% in 2011).
An in-depth discussion of trust income taxation is beyond the scope of this
article. However, the following general statements can be made, assuming
nothing to the contrary in the trust document:
8
§1014; Treas. Reg. § 1-1014-1(a).
§ 1015.
10
§§ 671 through 679.
11
An irrevocable grantor trust is often referred to as a defective trust (in our mind, an unfortunate label), meaning
effective as to keeping the assets out of the grantor’s estate but defective as to the income tax rules.
12
§ 641(b).
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Advanced Planning Ideas
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If the trust requires that all trust income be distributed to Mike and
Alice, 13 generally, taxable income other than capital gains is taxed
to them, even if the trustee forgets to make the distributions. 14
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If the trust does not require that income be distributed to Mike and
Alice, actual distributions to them can carry out some or all of the
trust’s taxable income to them by means of a concept known as
distributable net income (DNI). 15
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To the extent that Mike and Alice are not taxed on the trust’s
income, then the trust pays the income tax.
Confusion Gone? Susan has a clearer picture of the tax effects of using trusts. As to the estate
and gift taxation of trusts – the rules generally equate control with estate inclusion and the
relinquishment of that control during life as a gift. The income taxation of trusts can be very
complex and is very dependent on the particular facts. Nevertheless, income tax planning – and
significant tax savings – can be accomplished through trust investments, distributions and timing
of expenses. A client will need to consult with her tax advisor to take advantage of this type of
income tax planning.
Source: Advanced Planning Bulletin, September 2011
This publication is not intended as legal or tax advice; nonetheless, Treasury Regulations might
require the following statements. This information was compiled by the Advanced Financial
Security Planning Division of The Northwestern Mutual Life Insurance Company. It is intended
solely for the information and education of Northwestern Mutual Financial Network
Representatives, their customers, and the legal and tax advisors to those customers. It must not
be used as a basis for legal or tax advice, and is not intended to be used and cannot be used to
avoid any penalties that may be imposed on a taxpayer. Northwestern Mutual and its Financial
Representatives do not give legal or tax advice. Taxpayers should seek advice regarding their
particular circumstances from an independent tax advisor.
Tax and other planning
developments after the original date of publication may affect these discussions.
– To comply with Circular 230
13
Trust accounting income is different than trust taxable income. Trust accounting income is important in terms of
distributions and whether an expense or income item is charged to trust accounting income or trust accounting
principal. Much of this is dictated by the trust document and/or state law. For example, a short-term capital gain is
included in the trust’s taxable income; however, it is generally considered trust accounting principal rather than trust
accounting income.
14
§ 651.
15
§§ 651, 652, 661 and 662.
© 2011 The Northwestern Mutual Life Insurance Company, Milwaukee, WI
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